Wars Of Attrition.

On Thursday evening, we took an expansive look at the interplay between the trade negotiations, the government shutdown and the Fed’s dovish pivot.

Our contention, in essence, is that Trump risks negating the “dovish cover” he (finally) convinced Jerome Powell to provide by keeping the government closed and thereby raising concerns about how D.C. gridlock may impact the economy and markets in 2019.

In the absence of an outright relent on the balance sheet (i.e., an explicit move to tweak the pace of runoff or even halt QT altogether) it seems unlikely that the Fed will be able to offset another bout of market volatility by resorting to dovish rhetoric on rates. After all, they’ve already essentially ruled out further hikes in H1, although the irony (as ever) is that the further risk assets run, the more likely it is that a hike in March or June starts to get priced back in.

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A Two-Front War, Tariff Headline Hockey And The Updated ‘SG Swan Chart’

Well, in a new note, BofAML’s David Woo takes a look at all of this in the game theoretic context (as he’s wont to do) and his analysis is most assuredly worth highlighting.

He begins by giving readers some context, as follows:

The war of attribution game, formulated by the British evolutionary biologist John Maynard Smith in the early 1970s, is an important example of strategic interaction in game theory. Historians have used it to explain the seemingly irrational phenomenon of long and destructive wars (e.g., the western front of WW1). Economists have used it to explain why governments often wait too long before implementing the right policies. Below are the basic parameters of the game:

• Two players are fighting over a prize.
• At any stage of the game, a player can concede, allowing the other player to claim the prize.
• There is a cost to each player for continuing to play the game.

One of the key points we made in our Thursday evening post (linked above) is that conceding on either the shutdown or the trade war makes Trump look weak. Here, for those who missed it, are the relevant passages from our post:

The bottom line here (in case it’s not clear enough from the above), is that Trump has predictably boxed himself in. If he wants the fledgling stock surge to be some semblance of sustainable, he needs to either end the shutdown, strike a trade deal or, preferably, both.

The problem is that doing either of those things risks making him look weak. Don’t forget, the whole reason the government is shut in the first place is because Trump didn’t like the coverage he got on Fox News last month when it looked like he was prepared to sign the bipartisan bill to keep the government funded. Last May, Mnuchin struck a trade truce with Vice Premier Liu He only to see Trump immediately renege after Steve Bannon weighed in (which was absurd, considering Bannon was by that point nine months removed from having any official capacity in the administration) and the protectionist contingent threw a fit.

In his Friday note, Woo fleshes that out in the course of looking first at the shutdown before moving to the interplay between the D.C. impasse and the trade conflict.

“Like in the war of attrition game, both Trump and the Democrats are incurring a cost as the shutdown drags on”, he writes, before flagging a juxtaposition we noted earlier this week. Recall that according to a new ABC News-WaPo poll, 53% of Americans believe Trump and the GOP are responsible for the government shutdown, which became the longest in modern history last weekend.

That said, support for the wall has actually gone up over the past year. 42% say they support the idea to construct a barrier on the border, markedly higher than the 34% who supported the idea a year ago, a testament to the relative merits of fearmongering about “caravans”.

BofAML’s Woo flags the same poll, noting that “even though more Americans blame the President for the shutdown, support for the wall is increasing [and] meanwhile, both sides have been raising the stakes in the fight [with] Pelosi recently calling the wall ‘immoral’ while Trump declared the border problem a ‘humanitarian and security crisis’.”

That kind of rhetoric, Woo says, is “further complicating the effort to find a compromise”. As an example, he cites Lindsey Graham’s contention that “if Trump caves [on the wall], it’s the end of his presidency”.

In the context of the war of attrition game, all of this means that the shutdown – which is increasingly set to weigh heavily on the economy – “can last longer than what is in everyone’s interest”, Woo continues.

Obviously, all of this raises serious concerns about the debt ceiling fight, something we’ve been keen to pound the table on since the shutdown began. On that, Woo notes that while Mnuchin can “buy a few months by resorting to emergency measures” after the March 1 deadline, “sometime in the summer Trump will need the cooperation of the Democrats to avoid a default [and] the question is what the latter will ask for in exchange and whether Trump is prepared to pay the price.”

Moving on to how all of this plays into the trade conflict, Woo invokes our “two-front war” characterization from Thursday evening.

“Given the peril of fighting two battles at the same time, it seems reasonable to assume that the incentive for Trump to close a deal with China sooner than later has gone up”, he says, before cautioning that “Trump’s loss of full control of Congress may be viewed by Beijing as justifying a less conciliatory stance [and] with the shutdown in Washington and growing expectations that the Mueller report will be out soon, Beijing may decide that it is not in a hurry to close a deal.”

And there’s more. You might recall that earlier this week, we flagged headline beats on China’s December credit data as perhaps the first “evidence” that RRR cuts are beginning to “work”. Up until December, there was little evidence to support the contention that liquidity measures were bolstering credit growth in China, which may well have forced Beijing to ease more aggressively were it not for the fact that the Fed’s hawkish lean helped push the yuan lower.

One could easily argue that the uncertainty created by the shutdown played a role in precipitating the Fed’s newly-dovish demeanor which in turn pushed the dollar lower and put the brakes on the widening of the policy divergence between the US and China. That means the PBoC now has more scope to ease, given that said policy divergence isn’t being pushed wider on both sides anymore.

Woo underscores this. “The fact that the Washington shutdown is increasing the chance of a Fed pause, giving China a wider window to ease policy, could also reduce the urgency for Beijing to close a deal with Trump”, he writes.

And oh, the irony. If you couch the Fed’s dovish evolution partially in terms of the uncertainty engendered by the shutdown, it means that Trump, in creating the conditions that finally forced Powell to provide dovish cover, may have actually undercut his own leverage in the trade talks by freeing up scope for China to hold out.

To all of that, Woo adds the “yellow vest” protests in France which he says “could turn into another war of attrition, especially with the fast approach of the EU parliamentary elections (May 23-26).”

How all of this plays out will help determine whether the vaunted “recoupling”/ convergence theme pans out and also how (i.e., whether it’s a “benign” recoupling or a risk-off convergence. Here’s Woo explaining the key chart from the note:

Exhibit 1 maps the potential outcomes of the three political risks onto our three scenarios: the gridlock risk will largely decide whether we will remain in a decoupling world (bullish USD) while trade war risk will likely determine whether we get a good recoupling outcome (bullish EM) or a bad one (bullish Treasuries).

In addition to the obvious (which is that in a war of attrition, brinksmanship can persist, to the detriment of everyone involved), the bottom line is that, as Woo puts it in the executive summary found at the beginning of his Friday missive, “while the incremental cost of the game may be small, over time the cumulative cost can become very high.”

Unfortunately, market participants (and now, thanks to the shutdown, ordinary people) will end up bearing some of that cost.

And meanwhile, the headline hockey continues, with the following hitting the tape just as we finished penning this post:

• CHINA IS SAID TO OFFER PATH TO ELIMINATE U.S. TRADE IMBALANCE

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